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Sunday, March 23, 2008

Bear And The Wall Street Meltdown

In honor of Easter, I am required to quip We're all getting nailed now.

What happened:

The story of what’s happening on Wall St. is really pretty straightforward. It’s a classic bank run, this time on the investment bank formerly know as Bear Sterns, which we’ll just call by the apt acronym BS.

Over the past few months, folks who’d lent money to BS started to get worried that BS had made some bad bets with that money, and might not be able to pay them back. So they started calling in their IOUs.

When it started to look like those folks might be right—BS might not be able to meet the “margin calls”—the Feds got nervous that the firm could fail, and helped to orchestrate a bail out. Meanwhile, the firm went from being worth billions to being almost worthless in a matter of weeks.

There are many good articles out on this if you want to read up it. Go here, here, and in case you had a little residual love for BS in your heart, go here to get it expunged.

As for my contribution, I offer this primer.

Here’s what happened:

First, some firms that lend money made some big, risky home loans. The loans were risky because they ended up with lots of people who would only be able to pay them if house prices kept rising.

But the lenders weren’t that worried about the quality of loans because they didn’t hold on to them. They securitized them, meaning they packaged them with other loans and sold them to other investors.

Then the bubble burst and prices started to tank.

Then the loans started to go bad, but because they were squirreled away who knows where, no one knew quite what to do. So the part of the economy that provides credit froze up, and without free-flowing credit, our economy can’t expand.

As the losses piled up, well…see the BS story above.

The Federal Reserve and the Treasury are trying to unfreeze the credit markets by injecting “liquidity”—making a lot more cash available. But it hasn’t worked because investors are too spooked to lend and borrowers don’t want to invest anyway right now, what with the economy heading south with a vengeance.

All of which raises some very big, very good questions: What’s the risk engendered by these bailouts for the rest of us? There’s a good argument to be made for the bailout (see Krugman today) but not if the fat cats get to skate on by unscathed. At the heart of the bailout is the Fed taking on the very smelliest part of the BS portfolio: the mortgatge debt. I’d like to know what we’re getting in return (and Mr. Paulson, the answer: “smoothly functioning markets” is unacceptable).

And lest we forget, none of this had to happen. Market capitalism, once again, totally overshot, taking a fine idea—providing credit so that folks who aren’t rich can own homes—and slicing and dicing it until no one understood the financial Frankenstein they’d created. The government and the Fed turned a blind eye, which was fine with the “innovators.” Now that the monster has turned on them, they’re running back to the gov’t to bail them out.

The abandoned, foreclosed home on Caribe Street looked OK from the outside.

Inside, it was obvious that squatters - homeless people who stay the night in vacant houses - had invaded.

Plates with crusted food, empty beer cans and pillows were strewn throughout the home.

Used, wadded-up toilet paper piled high in the bathrooms.

"I wouldn't want to live next door to a house like that," Indio police Lt. Forest Meadows said.

It's a scene that's starting to crop up in neighborhoods across the valley - a byproduct of skyrocketing foreclosures.

Indio, with nearly 1,500 homes in foreclosure in the city's limits, is leading valley cities in taking a stand.

A new law goes into effect April 4 targeting abandoned homes with overgrown landscaping, stagnant pools and other eyesores that scream "empty" to squatters.

The law requires that abandoned properties be registered with the city and maintained. If not, the owner - usually the bank in foreclosed situations - could face fines or criminal prosecution.

"This is a nationwide problem. We're just being proactive. We're trying to get ahead of the game," Meadows said.

Other Coachella Valley cities are following.

In Desert Hot Springs, where abandoned homes also are being used for unsupervised parties by youths, a similar ordinance was approved Tuesday by its City Council.

In Palm Springs, the subject of abandoned buildings including homes was discussed at a recent City Council study session.

The problem Indio and other cities face with foreclosed homes is not knowing who the owner of a home is and who is responsible for its maintenance.

Homeowners are walking away from their homes without notifying their lenders, Meadows said.

And banks in some cases won't take responsibility for properties until more than six months into the foreclosure process, he said.

Meanwhile, the grass is dying, the landscape is overgrown, and mail and phonebooks are piling up.

Of the 1,480 homes in the foreclosure process, about 450 are bank-owned, Meadows said.

Nationally, foreclosures rose to an all-time high at the end of 2007 - the result of borrowers with adjustable-rate loans walking away from properties before their payments spiked.

Refinancing didn't work because of a lack of equity, or they couldn't meet the new loan standards.

In Riverside County, foreclosure filings rose 177 percent from a year ago: 7,549 in January compared to 2,721 foreclosures in January 2007, according to Realty Trac, a national foreclosure database.

Because Indio is the largest city with the highest housing inventory, Meadows said it's not unusual for Indio to also have the highest number of homes in the foreclosure process.

The nearly 1,500 homes in the city in the foreclosure process represent about 4 percent of Indio's inventory.

Meadows is not calling the situation a "crisis," but said it has caused a headache for the code enforcement department.

"It's probably one of the biggest things that has affected the city in (recent) years," he said.

Law applies fees

In Chula Vista, where drug users, transients and evidence of unsupervised parties have been found in empty homes, a law requires lenders to register the foreclosed home with the city.

They also must pay a $70 fee and are required to retain the services of a local property management company.

Meadows said city officials reviewed that ordinance and others around the state to create Indio's.

There, lenders will be required to register foreclosed homes with the city, and pay a registration fee. The city has yet to determine the price, but the fee is to offset the cost of enforcing the law.

Each property also is required to have a name and a 24-hour phone number of the local management company.

Not registering would be considered a misdemeanor, and the city can seek civil remedies or criminal prosecution.

"This ordinance will allow us to hold the lender responsible," Meadows said.

Brian Holcombe, president of FirstBank, said on the surface the ordinance seems reasonable, but in most cases unnecessary.

"If I had to register a home, from my perspective, that would be a bureaucratic administrative step that I don't think would add any value to the community," he said.

He said FirstBank doesn't have a single home in foreclosure in the Coachella Valley because they didn't initiate any sub-prime loans.

Holcombe said he guesses that most of the unkempt foreclosed homes belong to national lenders that don't have a local presence.

Stephanie Grant, assistant vice president of public relations for Wells Fargo, wrote that she could not comment on the law. But she e-mailed the following statement:

"We recognize that it's not good for a house or for a neighborhood when a home is vacant. We suffer significant financial losses whenever foreclosure becomes necessary, and neighborhoods may suffer from vacant homes. Wells Fargo has a strong business interest in selling a real estate owned house as quickly as possible."

With six code enforcement officers, the city won't be able to canvass every single home.

But if a neighbor calls or a resident notices an unkempt home, officers will investigate, Meadows said.

Getting ready, educating

The police department will educate lending companies and the California Desert Association of Realtors about the new law before it goes into effect, Meadows said.

Sue McCollum, president of the Realtors association, said she'd be happy to learn more.

"This is a concern of Realtors and of the actual neighbors in the neighborhood," she said. "It would be very beneficial to upkeep these homes, and it would be the responsibility of the people that own the homes to do that."

Indio Councilman Mike Wilson said he's relieved to have the new ordinance in place.

He had a squatter staying in a foreclosed home across the street and saw what it did to his Sonora Wells neighborhood.

"They were coming late at night and leaving early in the morning," Wilson said.

"If we're maintaining the front yard and pools and Jacuzzis it takes away the squatter or transient issue," he said.

In August 2007, investigator Eric Bremner found evidence in a shredder at Olympic Escrow that he says confirmed borrowers' complaints that they had never signed the mortgage documents that pushed them into a financial hell.

And why did Bear agree to sell out for $2.00/share? Maybe this is why?

The initial responses to my post below about what kind of pressure the Fed could have brought to bear on Bear Stearns to sell at vastly under its market value, if that in fact was the case (a proposition that I find difficult to believe from my vantage point of complete ignorance), suggest that there's no obvious answer to the question that everyone agrees on.

In other words, we've received no emails telling us about the little-known 'sell your $%& company for what we say or it's off to Gitmo' law being invoked.

But here are some possibilities. Berkeley economist and reality-based blogger Brad DeLong suggests two possibilities. One, that Bear Stearns execs were unwilling to go into bankruptcy because of a various forms of criminal liability they would face -- and that everyone would be so pissed about the collateral damage of the bank's collapse that everyone would want to not only execute them but also have them drawn and quartered (in case you only know the phrase and not what it actually means: not pretty). Two, there's so much crap on Bear Stearns' books that $2 per share is just a fair price, even with the Fed assuming a lot of the potential liability. Let's call this the Atrios option.

Brad says the market seems to believe two while he's leaning toward one.

More generally, a lot of what I'm hearing suggests that the some part of the answer may be that the Bear Stearns board and execs may have pursued interests not perfectly in line with their shareholders on this deal, whether that be to avoid criminal liability or protect their own compensation not directly tied to stock price.

Foreclosure used to be a last resort, something that hard-pressed homeowners would scrimp and plead to avoid. But as the subprime lending crisis sweeps up millions of borrowers nationwide, some are deliberately choosing foreclosure as an early option.

As their home values tumble and their mortgages rise, these "walk away homeowners" decide to cede their houses to their lenders.

"It's throwing good money away after bad" to pay an escalating mortgage on a home that's plunging in value, said Army Sgt. 1st Class Nicklaus Skaggs of Vacaville. He and his wife, Tishara, stopped paying their mortgage in February. They signed up with a new company called You Walk Away to help guide them through the multi-month foreclosure process.

The couple paid $455,000 for their Vacaville home almost three years ago, shortly after Nicklaus Skaggs returned from a year in Iraq. Now the home's value has dropped to $290,000. Their adjustable-rate mortgage, which started at about $3,000 a month, has reset twice, climbing to about $4,000.

They have no regrets about their decision.

"I feel like the pressure has lifted off my shoulders; before I was trapped," said Nicklaus Skaggs, 40, an earnest man who plans to retire from the Army in two years, after completing 20 years of service.

"If we keep paying the mortgage, we would really sink ourselves," added Tishara Skaggs, 35, who was an Army specialist driving heavy-wheel trucks until her lupus led to a medical discharge in 2002. The Skaggses have two daughters, Tabitha, 7, and Madisyn, 6 months.

No skin in the game

Walk-aways represent a profound shift in American attitudes toward homeownership - a shift that may have begun with the no-money-down subprime loans. People who don't have "skin in the game" - their own cash on the line - feel less attachment to their homes. People who bought homes expecting rapid appreciation may be quicker to dump them when they don't perform as expected.

The walk-away phenomenon is common enough that mailing in one's keys to the lender has earned its own nickname: jingle mail.

It is clear that many borrowers cede their homes without asking their lender for a break. More than half of foreclosures involve people who never spoke to their bank, studies show.

Housing counseling agencies said they would never advise clients to surrender to foreclosure without exploring other options.

"It never makes sense to literally just walk away," said Martin Eichner, director of the HUD program at Project Sentinel in Sunnyvale. "Even if you're hopelessly underwater, you should at least try to negotiate a short sale or deed in lieu of foreclosure where you give it back voluntarily. The worst thing to do is to let it go to foreclosure because it goes on your credit report as a black mark that follows you for years to come."

"When your house drops 20 percent in value ... it's better to walk away, even if you're wealthy," he said on TheStreet.com TV last summer. "Because you don't want to lose your credit card and you don't want to lose your car. Your house is the one thing that's fungible. It's smart to walk away."

New company offers help

You Walk Away (youwalkaway.com), based in San Diego, began in January to assist homeowners who want to let their homes go into foreclosure.

"What if you could live payment free for up to 8 months or more and walk away without owing a penny?" its Web site asks prospective customers. "Unshackle yourself today from a losing investment and use our proven method to Walk Away."

While going into foreclosure is free - you just stop paying your mortgage - Jon Maddox, co-founder and senior advocate at You Walk Away, said the company provides emotional, practical and legal advice that makes the process more palatable.

Customers pay $995 for an advocate to answer questions via phone and e-mail, a letter to their lender to stop dunning phone calls, consultations with a real estate attorney and a CPA, and assistance cleaning up their credit after foreclosure.

You Walk Away has served slightly more than 500 people in its 2 1/2 months of operation, Maddox said.

Maddox said 70 percent of his customers are financially floundering, while 30 percent made an economic decision to walk away.

"They don't care about their house anymore," he said. "It's a big weight around their neck. They're trying to get out of it and get their heads above water again. They're paying too much for the title of homeowner."

You Walk Away operates in California, Nevada, Arizona, Washington, Oregon, Colorado and Florida and is working to set up services for six other states. Maddox said the 13-employee staff will triple within a few months.

What about downsides? Foreclosure carries a range of financial negatives, but some are not as drastic as people imagine. Homeowners do not have to declare bankruptcy in a foreclosure (although some people do so because it temporarily halts the process, giving them more time in their homes).

An oft-cited fact is that a foreclosure stays on one's credit report for seven years. Many people assume they could not buy another house during that time.

But even the company that crunches numbers to produce credit scores says a foreclosure is not that devastating.

Jennifer Crawford, senior director of product support for Fair Isaac Corp. in San Rafael, said she would tell a homeowner being foreclosed upon: "All is not lost for the long term. Do not panic. You can absolutely take a structured approach to getting back in good credit standing. All other things being equal, in one or two years you can quickly build back up your credit standing."

The three major credit bureaus all use Fair Isaac's algorithms to calculate credit scores.

While a foreclosure does stay on a credit report for seven years, its impact declines over time, Crawford said.

"Let's take a scenario where you have a foreclosure but every other aspect of your credit profile is current - you've made all payments and have no other derogatories," she said. "If that is the situation, probably within a couple of years, you could be back in the high 600s or low 700s" - considered good credit scores.

Crawford said the impact of other steps short of foreclosure - missing payments, arranging a short sale, or returning the house as a deed in lieu of foreclosure - all depends on whether and how the lender reports them to the credit bureaus.

Tax consequences are another downside. Ordinarily, "canceled debt" such as a foreclosed mortgage is taxed as income. However, a law passed late last year mitigates this at the federal level until 2009.

Playing hardball with the bank

Some homeowners are sufficiently savvy - and brash - to try to turn the housing meltdown to their advantage.

A Discovery Bay man who asked not to be identified said he is "upside down" on his house by about $260,000. Instead of bemoaning the situation, he plans to capitalize on it.

"I refinanced a couple of years ago and pulled out $100,000 and put in a fabulous pool," he said. "Now I've got this fabulous pool and fabulous house, but it's not worth anything. Why shouldn't I be building equity over the next four to five years instead of playing catch-up?"

The man said he has not made a mortgage payment for five months.

"I'm playing the bank game," he said. "I'm playing chicken with them. I already got them to agree to put (the unpaid) payments on the tail end of the loan. What I'm really pushing them to do is to (adjust my mortgage) for the current market value and write off the rest. I'd love (to have it) lopped down to a $450,000 basis rather than $710,000."

If the bank won't negotiate, he'll walk away, the man said.

That kind of story sends chills down bankers' spines. To date, most loan modifications have involved freezing interest rates or repayment plans for arrears.

But no less an authority than Ben Bernanke, the chairman of the Federal Reserve, is now urging lenders to reduce mortgage principals so homeowners won't walk away.

"Principal reductions that restore some equity for the homeowner may be a relatively more effective means of avoiding delinquency and foreclosure," he said in a speech this month.

Not deadbeats

From their online research, the Skaggses know that bloggers have a lot of vitriol for walk-away borrowers, calling them irresponsible and worse. The couple say they have always paid their bills on time and feel they were given poor advice about both their mortgage and the housing market. Now they are in limbo, living among unpacked boxes. They returned a few months ago from a temporary posting to Fort Bliss, Texas, and stopped unpacking when they realized how high their mortgage would soar. They tried to contact their lender for a loan modification, but found the experience frustrating and their lender unresponsive.

Nicklaus Skaggs will be redeployed this summer, possibly to Iraq again. After he retires from the Army, they hope to buy a house in his hometown of Louisville, Ky. In preparation for that shift, he's studying for a bachelor's degree via correspondence school and then plans to pursue an MBA.

With no housing expenses during the eight-month-plus foreclosure process, they can save for a down payment, they said. Since so many people are now swept up in foreclosures, they hope that lenders will extend some grace to people like them, they said.

"In the long run, I think this is the best financial solution," Nicklaus Skaggs said. "I have to do what's right for my family. I don't care if someone judges me. I certainly wouldn't put my family in a position to lose $150,000 if I can help it."

efault rates in bay area

Foreclosure rates around the Bay Area vary tremendously. Cities such as San Francisco have few foreclosures, while outlying parts of Contra Costa and Solano counties are heavily impacted.